Flawed Incentives and Dubious Morals: JPMorgan & CDOs That Were “Built to Fail”

It’s been a busy week for JPMorgan Chase. It’s only Wednesday, and already the bank has settled one civil fraud lawsuit and been slapped with another one. Both shed light on Wall Street’s flawed system of incentives that helped bring on the financial crisis. They also raise questions as to the morals of bankers.

On Tuesday, JPMorgan agreed to pay $153 million to settle civil fraud charges brought by the SEC alleging that it “misled” investors when it sold them junky mortgage bonds. The deal in question was put together by Magnetar Capital. If you’re not familiar with Magnetar, it’s an Illinois-based hedge fund that made a killing shorting synthetic mortgage-backed securities that were essentially built to fail. Here’s how it worked: Magnetar would put down a few million bucks to start a collateralized-debt obligation (CDO), cram it full of the junkiest mortgage bonds it could find, then get a bank like JPMorgan to sell it off to investors as a triple-A, gold-plated piece of the booming housing market; when in reality it was a time bomb filled with toxic waste. Whatever Magnetar lost when the thing went bust, it more than made up by taking out massive short positions against it. For a real world corollary, consider this akin to building a crappy house, selling it to someone, and then taking out an insurance policy so that when it falls down or catches fire, you get paid big bucks. (For more on Magnetar, check out the amazing work NPR’s Planet Money and ProPublica did last spring.)

On Monday, federal regulators sued JPMorgan for allegedly duping credit unions into buying $278 million in mortgage bonds that were “destined to perform poorly,” ie, built to fail. Now, part of the reason JPMorgan emerged from the crisis relatively unscathed is that it realized fairly early on that the housing market was set to go bust; so it stopped investing so heavily in mortgage-backed securities. But it didn’t stop selling them. There was too much money to be made peddling these securities to people who were still bullish on the housing market. Was JPMorgan obligated to relieve them of this view? Of course not. Investing is like gambling. You think this horse is going to win, I think another horse is going to win; let’s see who’s right. Plus, all these deals came with “voluminous” risk disclosures stating exactly what was in these deals. So no one could claim they weren’t aware of what they were buying. What got JPMorgan in trouble is that they didn’t tell their clients that the deal had been put together so that a third party could bet against it. This is basically what got Goldman Sachs in trouble last year with the Abacus deal it put together for John Paulson.

Now, let’s consider the incentives.

We pay a lot of attention to incentives at Freakonomics. Understanding what motivates people, and how incentives align with outcomes can help uncover all kinds of interesting, unexpected things, whether you’re looking at school teachers or sumo wrestlers. It’s no different with investment bankers and CDO deals. See, the bankers at JPMorgan who sold these CDOs got paid regardless of how the things performed, whether every one of the thousands of mortgages stuffed into them paid off, or whether they all defaulted. So the incentive for the bankers was to sell as many CDOs as possible, even if they knew they were going to blow up in a year or two. It wasn’t their problem because it wasn’t their money. This raises an obvious moral question: were bankers morally remiss in pumping these mortgage bombs out into the world when they knew the wreckage they would cause? Or were they simply being good at their job? Maybe, but then how morally remiss are tobacco companies or fast food restaurants? Whether it’s cigarettes or food loaded with trans fats, society has essentially deemed that when it comes to things that aren’t good for us, as long as we know the facts, it’s buyer beware. The CDO equivalent of the Surgeon General’s warning are those risk disclosures describing what sorts of mortgages they contain. Apparently, not many buyers read the fine print.

Assuming he had the correct view of the housing market back in 2007, a “moral banker” was someone who ended up leaving a lot of money on the table. Considering the incentives as they were, how morally remiss were these bankers?

Any banker has been educated enough to understand the risk of the product their selling. But no average Joe banker selling CDOs would have even thought the recession would hit so hard. They kept “betting” on the idea that the bullish economy would continue and their customer would be safe. As for the morals of the Magnetar company. They understood the risk. Why else would they buy the insurance. Chase, and other companies, need to look into these business ideas much closely to protect their customers.

The bridge ahead has been swept away by a raging, flooded river. Instead of putting up a barricade, I put up a sign that says something like, “Please understand that driving this way involves risk.”

The difference, in a nutshell, is the claim that a PASSIVE warning against impending doom is just as valid as an ACTIVE warning. That is, a long-winded, small-print prospectus which few people read in its entirely (except the lawyers, who have read every single word many times) is supposed to absolve JPMorgan Chase of the deaths of family nest eggs, of the lost dreams of hard-working families, of the stress and pain caused endured when people drove over the precipice into the swirling waters below?

When the dice is loaded against your customers, and you don’t tell them except by using generic legalese that is used even with the finest investments, that is a massive moral failure. Those “investors” were buying nothing more than lottery tickets. Yes, they maybe, possibly, just perhaps, might have come out winners…but the odds were highly against such an outcome.

You can be CERTAIN that the risk to Chase was carefully weighed by managers in the know. In fact, for all we know, JPM had already carefully calculated just how much any settlement might cost them. If so, you can be sure that JPM would never have proceeded unless the gains outweighed the risk. You know, kind of like car manufacturers who know that there is a lethal flaw in one of the models, but figures that only one person in 15,000 will actually die, and at an average settlement of X dollars per death, will only cost the company $20MM dollars, against a profit of $300MM. And so the flawed car goes to the showroom.

The way to handle such activity it to do more than take “chickenfeed” from the company. EVERY SINGLE PENNY MADE ON THIS PRODUCT should be part of the settlement, AND a strong punitive charge should be added, as well. Basically, the investors should get back every single dime they lost. Why not?

If JPMorgan represented junk CDOs as triple-A investments, that is fraud, pure and simple. The fact that they stopped buying (but not selling) these CDOs certainly suggests they had done their due diligence and knew them for junk.

And brokers *oppose* a universal fiduciary standard that would, in future, require them to place their clients’ financial interests ahead of their own.

But unfortunately risk disclosures and the “caveat emptor” doctrine only apply to the transaction between investor and investment seller; what about the millions of innocent bystanders who did not participate in these shell games, but lost their jobs, their homes, and their life savings as a direct result? In this case, what’s the difference between a Wall Street banker and a drive-by shooter?

We are moral relativists, despite the attempts by the religious to impose versions of absolute standards on us.

Consider a person working for a railroad in Nazi Germany. He schedules trains and he knows they carry people to very bad places. But he has a wife and 2 kids. Literature is often about our complicity because we are complicit.

Please don’t take the “morality” angle. We’re not going to solve these problems by demanding that people be more honest. Stick with the incentives angle. The point of this is that you need regulation in spots such as this where the incentives are perverse. How can we let people buy insurance for things where they have no skin in the game (rhetorical question, of course, because the answer is that big finance has way too much political power)? Your home insurance scenario is an appropriate analogy. Or, it’s like letting me buy an insurance policy on YOUR life. Gives me an incentive (admittedly morbid) to hope for you to die or even worse, to kill you.

And yet, we continue to allow our legislators do the work of the finance lobby. Where has the journalism profession gone. What a downer. Wow, I’m really depressed now. I think I just ruined my day. . .

1. I agree with Margret that there was fraud in the CDO ratings practices. This introduced a level of information asymmetry that cancelled out the risk disclosures for many investors.

2. The bankers who knew the CDOs were built to fail, and shorted them to mitigate risk, definitely engaged in ‘moral’ hazard.

Information asymmetry and moral hazard combined is enough for me to say, with confidence, that continued selling, without disclosure of the junk status and shorting, was indeed an immoral act.

It remains to be seen whether SEC civil actions, and changes in regulatory enforcement, will counteract the incentive structure, and prevent this type of behavior in the future. All indications are the settlement amounts are a drop in the bucket for JPMC, GS, etc. If that is the case, morality has little to do with the outcomes.